Optimal Illiquidity

December 2020

Recognizing households’ needs for flexibility, while discouraging overconsumption, how much liquidity should be built into a socially optimal savings system?

Summary

The government chooses mandatory contributions to respective spending and savings accounts, each with a different pre-retirement withdrawal penalty. Penalties collected by the government are redistributed through the tax system. This paper calculates the socially optimal level of illiquidity in an economy populated by households with taste shocks and present bias.

Key Insights
The constrained-efficient social optimum is well-approximated by a two-account system, with one account that is completely liquid and a second that is completely illiquid.
If a third account is added, its optimized early-withdrawal penalty is only slightly above 10%.
In equilibrium, the leakage rate from the partially illiquid third account is high, with the rate varying depending on the calibration.
While these properties have analogs in the retirement savings systems in the U.S., the findings do not demonstrate the social optimality of the U.S. approach.
Methodology

The authors evaluate the optimality of an N-account retirement savings system with a combination of liquid, partially illiquid, and/or fully illiquid accounts. The illiquidity is obtained with linear penalties for early withdrawals. Within this framework, they focus on two special cases: systems with two accounts and systems with three accounts.

Until now, no normative model has been used to determine whether leakage from retirement accounts is good or bad from the perspective of overall social welfare.
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